Design and Renegotiation of Debt Covenants

Abstract

We analyze the design and renegotiation of covenants in debt contracts as a specific example of the contractual assignment of property rights under asymmetric information. Specifically, we consider a setting where managers are better informed than lenders regarding potential transfers from debt to equity associated with future investments. This simple adverse-selection problem leads to the allocation of greater ex ante decision rights to the creditor (the uninformed party), i.e., tighter covenants, than would follow under symmetric information. This corresponds well to empirical evidence indicating that covenants are very tight upon inception and are frequently waived (and never tightened) upon renegotiation.

Source: resolved